If The Curve Doesn’t Get Steeper Soon, One Strategist Is Going To Lose His Mind

So you should care about the evolution of rates strategists’ forecasts for the yield curve because, well, because in many respects, the entire reflation narrative hinges on the trajectory of yields and the shape of the curve.

On strategist who has had a bit of a tough time reconciling the abrupt “pause” in the post-election rates selloff with his previous forecast is Deutsche Bank’s Dominic Konstam. To be sure, Konstam’s weekly notes are good and are always worth a read, but you’d certainly be forgiven for saying that the his last half dozen (or so) missives have felt a whole lot like attempts to talk around the rather obvious fact that the Treasury selloff thesis just hasn’t played out and relatedly, that bull flattening is a distinct possibility going forward.

A couple of weeks ago, Konstam threw in the proverbial towel, when he “shifted his forecast for yields ‘forward’ in recognition of the failure of the new Administration to make any progress on structural tax reform let alone outright fiscal stimulus.” Here’s an excerpt:

Unless there is a new approach with bi partisan support, the risk is that tax reform turns out to be a half hearted gesture with little positive impact on potential growth let alone actual growth.The only difference between pre and post election would then be a Fed that was suckered into a faster pace of tightening on false hopes.

Then, a week later, Konstam called for a “tactical rally” and bull flattening. Here’s what he said:

A disruptive outcome in France could also produce two phases of curve adjustment, as Fed re-pricing (probably quickly) segues into a deeper risk off trade whereby risk assets roll over and breakevens decline, producing a sharp bullish flattener.

A week after that (so, two Fridays ago), marked the “fuck it” moment. To wit:

Sit back, relax, the bear market may be over. One can’t help but think that if output momentum is rolling over, then we have alre`ady seen a clear signal of the rollover in yield momentum and if that is the case the recent (local) bear market is over and the only question is the extent to which it can unwind. Ironically the bear market, since it was never that strong, failed to break the long run decline in global yields. If the bear market in bonds is dead, the bull market may never have noticed.

Ok, well fast forward one additional week (to yesterday) and we of course did not get an unfavorable outcome in France and tax reform is back on the table (if by “on the table” you count a double-spaced, wide-margin one-pager that looks like Kellyanne Conway might have typed it up in Word 15 minutes before Trump dispatched Gary Cohn and Steve Mnuchin to tell the press what it meant).

That means Konstam can now get back to talking about a steeper curve. Here are excerpts from his latest…

Via Deutsche Bank

Still Like Steepeners

Our outlook for the US market remains one of modestly higher yields and a steeper curve. With the first round of voting in France in line with the polls, we are more confident that the second round will not prove disruptive and expect markets to refocus on the Fed and the prospects for the Trump administration’s fiscal agenda.

As we have argued in recent weeks, the abrupt sell-off following the US elections reflected a high degree of confidence that the Trump administration would be able to successfully pass the key points of its fiscal agenda, and that stimulative tax and spending policy reform would “work”. From a longer term perspective, “success” would entail engineering a demand shock that would induce increased investment and ultimately, higher productivity. Higher productivity would increase potential growth and r* and enable yields to break sustainably higher from the low growth, low inflation, low rate equilibrium in which the market has been mired since the financial crisis.

The sell-off paused due to concerns about potentially disruptive results from the French elections, and due to the reality of legislative frictions that could dilute the stimulative impact of the Trump economic agenda. While round one of the French elections implied a smaller probability of a disruptive outcome, uncertainties around the political viability of the Trump administration’s economic agenda remain substantially unresolved.

The initial failure of health care reform has complicated President Trump’s tax agenda in that absent savings from health care, there is greater potential that tax reform could be significantly additive to the deficit. While the right wing of the Republican party has suggested that it sees some flexibility in accepting higher short term deficits stemming from tax reform, the risk is that higher deficits could render the ultimate tax package far less stimulative than the administration’s ambitions, and hence less likely to break the post-crisis equilibrium. Moreover, some forward looking indicators suggest that activity could slow going forward. For example, last week we illustrated that declining excess liquidity implies a slowdown in growth momentum, which itself historically has marked the peak of G3 yields.

There is, however, still a plausible path higher for yields. The first component of this path is the Fed. Presuming a Fed path of two additional hikes in 2017, and then two hikes each in 2018 and 2019, fair value for the 2y Treasury is 1.82%. Assuming a constant money market slope of 6 bp/annum after the “terminal” Fed level, fair value for 5s adjusting for the Treasury/OIS spread is 2.42%. With these yields fixed by assumption, we can then apply a metric of the term premium to solve for 10y yields. We have found that a simple proxy for the term premium consisting of the 5s10s slope minus 20% of the 2y yield, has been highly correlated with ACM term premium that has gained currency as a benchmark representation of the term premium. Using this approximation, fair value for 10s is 2.77%.

From this base scenario, we can then examine scenarios for the term premium. For example, in the table we repeat the exercise for an assumption that the term premium converges 50% of the way back to average levels in Q2 2014 by the end of 2017, and 75% of the way back to this baseline by the end of 2018. This convergence of term premium is consistent, for example, with partial SOMA unwind, the potential impact of domestic fiscal policy, and ultimately with an ECB taper.

At current levels, we find the 5s10s Treasury slope 9 bp too flat.Our model posits 5s10s as a function of 5y5y forward inflation, QE flow effects, implied volatility, and the 1y ahead budget balance, and explains 93% of the variability of 5s10s. To optimize positioning around this core steepening view, we examine a broad range of steepening positions in spot and forward swaps from the perspective of curve slide and implied curve volatility. From this mean/variance perspective, we consider curve roll as expected (ZV) return, and use curve implied volatility as our dispersion parameter. “Optimal” steepeners maximize expected return when normalized by spread volatility. We iterate on a broad range of steepeners, normalize return by return volatility, and sort in descending order of the ratio of return to return volatility. We then provide the correlation of changes with changes in 5s10s Treasuries, and then illustrate the historical beta of the position relative to 5s10s. For example, 3m2s30s has positive 1y carry of 33.4 bp, implied curve volatility of 38 bp, which creates a ratio of roughly 0.9, the 79th percentile of the 10y distribution. 3m2s30s has displayed a correlation with 5s10s Treasuries of 78%, but changes on average were 1.68x the change in 5s10s.

Writing about a subject is the best
way to educate yourself about it, and when I flick through past work I remember how much
they taught me, if no one else. Mainly they taught me that I didn’t know very much. But they
also taught me that most other people didn’t know much either. Thus, some key themes
which stand out include the illusory control of policy makers, the presumed knowledge of
those looking to them to actively do good, the ease with which we fool ourselves, and how
best to protect capital in the face of such unavoidable uncertainty. -- Dylan Grice